Sunday, June 26, 2011

Here's a piece by Robert Higgs, expressing doubt that the execss reserves injected by the Fed won't ever result in hyper-inflation. In a key part, Robert states:

"I'm not convinced that these gigantic sums will not, sooner or later, still become the fuel for hyperinflation, or at least for a greatly accelerating rate of general price inflation, which economists expected they would be before the recent recession and all of the government’s and the Fed’s extraordinary responses to it occurred. Second, I am not convinced that the banks will remain content forever with earning a negative real rate of return on their holdings ... If they were to realize only the difference between the rate the Fed is paying them and the rate they would earn by lending these funds exclusively to prime customers — an increase of 3 percent on their return — they would gain an additional $45 billion in income. ........ I understand, of course, that banks are seeking to repair their damaged balance sheets, in light of their recent debacle in real-estate-related investments of various sorts and in conformity with the new Basel requirements for increased bank capitalization. Still, I am not convinced that these consideration can account fully for the very curious conditions now existing in the banking industry." The rest of article is here.

My own position is: Reserves have nothing to do with how much banks will lend, and does not determine whether and how much hyperinflation can happen. Banks will lend when they want to lend, whether they already have the reserves beforehand, and even if they can’t get at any more new reserves, will securitize if they have to. Hyperinflation will not be caused by having too much reserves in the banking system per se, but by having too much demand in the general economy.

When demand comes back, even if the Fed has withdrawn all excess reserves, the securitization market will have reanimated back to life, and banks will lend again. (And they will likely lend too freely if capital standards remain weak). So the best way to prevent a hyperinflation is to constrain bank lending directly with more stringent regulation. Pushing reserves into the banking system is a failed experiment by the Fed, and we should not allow ourselves to be misled as well by its efficacy. If we do, we'll miss the real problem of weak regulation. Weak regulation is what will bring us back to the conditions of 2001-2007. I posted a similar theme here.

Also, for as long as the private sector is overindebted and still deleveraging (in balance sheet recession), I believe we will be far away from the risks of having too much demand in the general economy. Better to be worrying about deflation instead for now, while also preparing for the day banks start thinking along the lines of Robert Higgs'. Your thoughts.

Hans, these are excess reserves pushed into the banks by the Fed via QE2. Fed bought Treasuries owned by banks in exchange for cash at the Fed. i.e., reserves.

I can't be sure, but perhaps Prof. Higgs uses the fractional reserve banking framework, which believes every $1 of reserves can be relent 9x. If you already believe reserves BY THEMSELVES can cause inflation, there's no reason to not believe they cause hyperinflation. Of course, if you believe instaed that loans are caused by loan demand and banks' capital adequacy, then $1 lent by bank A does not mean that bank B, which gets it as a deposit, relends to the next person. Bank B may may capital-deficient, or may not focus all that much in loans (perhaps it likes to place money instead in commodities plays).

exactly. couldn't agree more. It's as obvious as the light of day but still for some reason people think "regulation" equals "inefficiency." ugh

Better to be worrying about deflation instead for now

yup. why is this so difficult for people to grasp?

Higgs states, "Second, I am not convinced that the banks will remain content forever with earning a negative real rate of return on their holdings"

what is he referring to with "negative real rate of return here? Is that b/c the rate of interest on those bonds is lower than the current rate of inflation?

My one concern with the excess reserves from QE2 is if plain jane banks are not considered separate from their investment bank divisions. I don't know the ins and outs of how banks can exercise their reserves (could they be both the lender and the lendee for example)...I'd imagine that such "loopholes" are out there and this could lead to a "legitimate leakage" of those reserves into various investment vehicles and just wreck havoc in our financials. I don't know but I thought that such asset allocations could happen now with these banks no (aka a carry trade type scenario or something like that)?

Negative rate of return likely refers to what mainstream monetarists call 'expected future inflation', which convinces people to put investments in higher risk-return investments to compensate for the higher expected inflation.

This most affects money managers, who are expected to achieve minimum hurdle rates of return, which are now impossible due to the longstanding zero bound for treasuries.

So it's not the reserves of banks being put into high risk investments, but more likely the asset pools of money managers, which now have nowhere else to go (since the Fed has crowded them out of risk-free treasuries)

Hans, I don't even believe that 9x is even a useful benchmark. Banks will lend when are willing and able, regardless of existing level of reserves. The ability comes from equity capital cushion and the wllingness comes from demand from creditworthy borrowers.

With regard to 'hyperinflation', I think it only ever happens when there is a general loss of faith in a currency, which results in mass flights out of it. Bank reserves have nothing to do with this phenomenon. 'Helicopter drops' of money to the general populace is more likely to do it.

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"Conventional approaches, unconventional conclusions" on the global finance and economic issues of the day. Rogue Econ has been a banker and financial consultant in several countries. Welcome to my blog.